Did The Fed Help Banks While Ignoring The Risks?

Since the financial crisis of 2008, the Federal Reserve has shrugged off warnings and let the largest U.S. financial firms pay tens of billions of dollars in dividends to shareholders, instead of putting aside money as capital in case a new financial crisis hits.

Investigative reporter Jesse Eisinger details how the Fed made a critical oversight in the wake of the financial crisis despite objections from the Federal Deposit Insurance Corp. His report was published jointly by ProPublica and TheAtlantic online.

The head of the FDIC warned the Fed that banks were not able to "withstand stress in an uncertain economic environment," just as the Fed was looking at whether banks could pay dividends to their shareholders, Eisinger says.

Even though banks passed the Fed's "stress test," Eisinger tells Fresh Air's Terry Gross, many regulators and Fed employees believed that the banks were not as strong as the tests might indicate.

"This was a very generous decision for the banks," Eisinger says. "They were able to pay millions to shareholders amid huge uncertainties."

Those uncertainties include the financial crisis in Europe, as well as ongoing legal liabilities for banks involved in the housing crisis. A year ago, the banks admitted to using fake signatures or affidavits to sign foreclosure documents a practice known as robo-signing. Five major banks and more than 40 state attorneys general recently agreed to settle with some of the homeowners affected. But there's still an ongoing investigation, and President Obama recently assigned the New York state attorney general to a task force investigating the matter.

"This is an ongoing legal problem that is metastasizing and shows that the financial crisis is still with us," Eisinger says.

It remains unclear, he says, if the ongoing problems with the banks were taken into account during the Fed's stress test.

"The FDIC, which is one of the major bank regulators, didn't think so," he says. "They had a lot of concerns that the Federal Reserve which was conducting this stress test in late 2010 [and] early 2011 had not really taken into account either the European financial crisis or, more acutely, the legal liabilities [facing the banks.] ... So there was a lot of concern that they were shunting aside these major issues on the horizon for the banks."

In November 2010, Sheila Bair, the head of the FDIC, wrote a letter to Fed Chairman Ben Bernanke warning that banks were not ready to pay dividends because they didn't have strong-enough earnings or solid-enough assets.

"Unfortunately, Sheila Bair and the FDIC didn't have an official say in the stress test and they were kind of shunted aside," Eisinger says. "And it was really up to the Fed and the Fed ignored those warnings."

The banks which heavily lobbied the Fed were given the go-ahead to pay billions in dividends, which went to both shareholders and executive compensation packages. Dividends are taxed at a much lower level than salaries.

"Why would they want to pay dividends? It's not just to shareholders. ... It's to executives, because executives at banks get paid in stock, largely, so they benefit personally when they get dividends or share buy-backs," Eisinger says.

The Fed has to make incredibly complex decisions while balancing a lot of different risks, he says.

"I'm not envious that they had to go through this," he says. "A lot of this is about confidence building and psychology. If investors are more confident, the stocks will go up, the banks can feel more confident about lending, they can sell stock at a higher price. All these things build on each other, and the Fed is constantly worrying about investor sentiment. But the danger there is that you get caught up in that and you do things for PR reasons rather than sound financial reasons because you think that confidence will take over and then it becomes something that you've done for appearances rather than solid financial reasons."

Interview Highlights

On potential financial crises without a cushion

"Certainly, the European financial crisis is the most obvious one. Italy and Spain could have problems financing their debt. And if that happened, people would be very worried about the solvency of those banks, and they might have exposures to other countries and U.S. banks might have exposures to those banks which would make investors very afraid. So what you want at the U.S. banks is big, big cushions to try to assuage those worries. If you really wanted to have a really safe banking system, you want to have much more capital than we have now, to absorb the losses before shareholders take a hit and the government has to come in and bail the banks out again."

On the banks before the bailout

"They probably were insolvent. Probably most of the big banks, if not all of them. And the federal government invested in the banks to save them. And then the central bank, the Federal Reserve, gave them literally trillions of dollars in low-interest loans. And those were incredibly profitable. The government got very little in return for that. We invested in stock where we didn't have voting power and we didn't have a lot of rights or a lot of upside if the banks got through this. So we ended up making money when we invested in the banks but not as much as we may have. And that was a very generous decision to those institutions, to the employees, to the executives, to the shareholders of those institution the government paid a lot of money, took a lot of risk, and got very little in return for it."

On restrictions placed on the bailout money

"There was no restriction on bonuses and there was no requirement that they had to lend the money out, which means that people have had a much harder time than expected even though interest rates have fallen [doing things like] refinancing their mortgages, getting new loans to start new businesses, there's been a very severe tightening of credit. And the Federal Reserve's goal was to loosen credit but bank bonuses to executives have been pretty high steadily in the years after the financial crisis."

On the state of the Troubled Asset Relief Program

"It's almost all paid back, with few exceptions. The Obama administration points to this as one of the rousing successes. Of course, the TARP was started under the Bush administration but it continued under the Obama administration. And the government made money. So that's obviously a good thing. It was a winning investment. The question is whether we got enough. We didn't really make as much money as we could have. We didn't get a lot in return. We didn't require banks to lend the money out or have restrictions on bonuses or even couple repayment with financial regulatory reform that was separate. So it was a partial success a B/B+, maybe."

On the Fed's reaction to the housing bubble in 2005 and 2006

"They were laughing about whether there was a housing crisis brewing or a housing bubble. That's one of the big takeaways from those minutes [which were just recently published.] Economists respected economists, they weren't just chicken littles were talking about a housing bubble in 2005, even, and certainly in 2006 when the housing market peaked, and yet the Fed was extremely dismissive of it. It's really a shame and a scandal. It was even worse that they failed to foresee the financial crisis in any way. They had overseen the banks and they'd let them run amuck. The major banks in the United States became very vulnerable under the Fed's watch."

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